Apaxâs decision to move away from investing in early-stage companies, revealed in Financial News last week, is surprising only because it has taken so long. Most mainstream private equity firms got out of the sector some time ago because of costs.

Bruce Macfarlane, MMC Ventures

It is difficult to make an economic case for fund managers to invest in lot sizes below £5m. It takes the same time and resources to make and manage a £2m investment as it does a £20m one. So the economics of fixed-cost leverage drive private equity funds to carry out larger deals. This has encouraged them to raise ever greater funds from investors, further exacerbating the equity gap issue.

This is the problem of the early-stage sector, where companies require between £250,000 and £2m and where it is perceived that venture capital in the UK is in short supply. The Treasury was sufficiently concerned to launch a consultation and is proposing to introduce Enterprise Capital Funds to match private capital allocated. This is an imaginative initiative, drawing on the experience of Small Business Investment Companies in the US, and is expected to release between £200m and £300m of new money for early-stage growth companies.

However, it is not investment money but lack of operational resources that is the problem for early-stage investors. Early-stage companies need much more than money. They often have to strengthen the management team, find the right chairman, determine the merits of third-party distribution versus direct sales, identify routes into target customers and evaluate strategies for international expansion. Most small companies cannot afford to take advice to address these issues and most private equity firms have decided that they cannot justify the time and cost to help them do so.

Sophisticated angel investors are the answer. In return for the right to invest on fair terms, business angels will provide value-added advice and support at little or no incremental cost.

There are many examples of individuals prepared to devote significant time and capital to one company. Most, however, want exposure to a diversified portfolio of interesting sectors. The difficulty is that without some sort of infrastructure, an informal angel group lacks the ability to conduct appropriate due diligence, structure deals and documentation and attract consistent quality dealflow.

This was MMC’s experience. We started as a group of like-minded individuals, which now includes bankers, directors, management consultants, lawyers and IT entrepreneurs, keen on making early-stage investments and prepared to nurture them. But none of us had the time to conduct due diligence and ensure attractive dealflow. The solution was to create an engine room of highly qualified professionals who could do this.

The costs of such an exercise are not to be underestimated and they explain why there are so few organised angel syndicates. Angel investors need support – careful sifting of dealflow, proper due diligence on chosen companies, appropriate structure of investment and co-ordinated post-investment support.

How can this be funded? One obvious route is by charging each investee company a corporate finance fee. But this can lead to deals for the sake of fees and small companies cannot afford much. An alternative route is to charge individual investors but MMC’s high joining fee of £10,000, the highest of any investor club we know, does not cover all our overheads.

Statistics show that early-stage investment has the highest return of any private equity class if it works and the lowest if it does not. If the UK is to exploit its potential as a knowledge-based economy, it needs to accelerate angel investments. One way would be for large private equity firms to sponsor or assume the operating costs of angel syndicates so the angels can get on with mentoring. The return of the likes of Apax would be preferential access to a sifted and developed dealflow.